The Value-Added Tax: State and Local Implications

A threat or an opportunity?

The Value-Added Tax has reportedly resurfaced in Washington as a possible future revenue source to help balance the budget, pay for Medicare and Social Security or possibly fund part of the national health care system.

For those unfamiliar with the VAT, it operates like a national sales tax, but is collected at each stage of the value-added process in the economic food chain. A VAT tax is collected when iron ore is mined, when the ore is smelted into steel, when steel is forged into wire or tubes, when steel tubes are used to drill oil, and when oil is refined; it's collected when wheat is milled into flour or cereal, when bread is baked, when cereal is packaged and then transported. It's also got its hand out when vegetables are flash frozen and plastic-wrapped, and when a drug company packages chemicals into a pill. Each stage of the value-added process is subject to tax, so that every level of economic activity throughout the nation becomes a revenue source. Ultimately, of course, the consumer pays the taxes through the final cost of the products. Even services can be subjected to a value-added tax, so that a doctor or psychiatrist, or a plumber or financial adviser can theoretically be subjected to value-added taxes if they are defined that broadly.

Other countries have levied VATs for decades. In places like Europe where shoppers cross borders all the time, a VAT is a clever way to get nonresidents to pay part of your bills. As a levy on consumption rather than income, it is deemed to be less hostile to capital formation.

The VAT has its pros and cons. Some people hate it as a regressive tax, others prefer it to income taxes and some want to compensate for that by marrying it to a high-income tax. Those debates typically follow partisan or ideological lines. I'm going to avoid those debates and focus here on the potential pragmatic impacts, both positive and negative, for state and local governments.

A VAT is typically opposed by state and local government finance groups. The fear is that a national sales tax will crowd out their own sales taxes. Sales taxes represent a major component of state revenues, and a sizable source of local government revenues (especially when state subventions and revenue-sharing formulas are considered). To the extent that Americans begin to resent paying taxes at the cash register as a result of a new VAT, they are likely to disapprove local ballot measures to raise local sales taxes.

On the other hand, there might be a way for the federal government to co-opt or at least appease the state and local government lobby by sharing part of the VAT revenue with them. First of all, a point-of-collection, revenue-sharing formula could be included in the VAT law, so that the actual tax collector receives a cut of the revenues. Second, there is an opportunity to put an end to the ongoing battle over Internet sales taxes by including those transactions in the VAT, and then sharing that revenue with state governments. Following action by New York, other states are hungry to get a piece of the online retails sales action, and a bill has been introduced in Congress to promote a national online sales tax. Following a Supreme Court decision against arbitrary and overcomplicated online sales taxes, the online marketing industry has thus far successfully outflanked efforts by state governments to collect sales taxes on Internet sales, but a federal VAT initiative might trump their lobby.

Finally, there is another aspect of a possible VAT structure that could provide a gold mine of revenues for states and localities, if Uncle Sam plays his politics wisely: the services industry. A VAT can capture the value added by service providers who traditionally are exempt from sales taxes in the U.S. Our economy shifted from predominantly producing goods to services 30 years ago, and a VAT on services could produce as much revenue as the sales tax. In Europe, for reference, a wide variety of services are subject to VAT.

If the Administration and Congress decide to pursue a VAT system, they would be wise to include the nation's governors and mayors in that dialogue. By capturing and sharing revenues from sectors of the economy that escape state and local taxation, a federal VAT system could bring greater tax equity to the entire economy.

As with any other tax, there are advocates who seek revenues for public services or simply to balance sustainable budgets, and critics who believe government already takes too much from people's pockets. Others object to VAT as another way for Big Brother to inject himself into every aspect of American life. I'm not taking sides in that debate -- just noting that from an intergovernmental revenue system standpoint, a VAT has something to offer the state and local sector, if it's wisely crafted. Smart governors and state tax administrators might best plan how to board this train early rather than trying to derail it.